From Bad To Worse: Seagate

About: Seagate Technology (STX)
by: Value On The Street

Seagate pre-announced its fiscal third quarter results last night and they were lousy.

There are zero reasons to be bullish Seagate and many reasons to be bearish.

Any investor thinking the dividend is safe is wrong. I suggest selling now before the cut comes.

Last night Seagate Technology (NASDAQ:STX) preannounced its fiscal third quarter results. They were, in a word, awful. Revenues are expected to be in the range of $2.6B versus guidance of $2.7B. The $2.7B is down from previous street expectations of $2.8B just 90 days ago. $2.6B in Q3 revenues represent a 21.9% decline on a year-over-year basis, which is an acceleration from the Q2 decline of 19.2%. Gross margin is expected to be in the range of 23% versus guidance for 25.6% and previous margin of 24.8%. Total drives sold fell to 39M units, down a whopping 15% from the previous quarter. The total addressable market or TAM for HDDs is declining at an alarming rate. Shares are crashing so far this morning, down 18% at the moment.

What's Happening?

Seagate is experiencing weakness across its product portfolio. In the press release, it cited reduced demand for mission critical HDD enterprise products, storage arrays, SSDs and client desktop and notebook drives. We knew client would be weak, but the weakness in mission critical enterprise drives is particularly concerning for the bulls as enterprise is always what they point to as the savior for the company. The fact of the matter is that SSDs are coming for the enterprise business quicker than most expected. When storage array makers EMC (EMC), NetApp (NASDAQ:NTAP) and Hewlett-Packard Enterprise (NYSE:HPE) report later this earnings season, I expect them to report large increases in all-flash arrays (70-100%) and modest declines in traditional HDD storage arrays as this has been the pattern in recent quarters. Also concerning for the bulls was the weakness the company pointed to in its silicon products, aka SSDs. As I have stated before, competition in enterprise SSDs is intense, and without its own silicon Seagate is at a pricing disadvantage. Anyone thinking SSDs will save Seagate will likely end up being sorely disappointed.

The main takeaway from these results should be the following. First, Seagate has very poor visibility into demand for its products. This is very concerning. The company's ability to accurately forecast demand for HDDs is impaired due in large part to disruptive technology, slow global growth and the strong US dollar. The inability to accurately forecast demand is a bad sign and means that the company will have a difficult time managing its expense base. It also means that guidance should not be relied upon. That leads me to my second takeaway: margins will remain under pressure. We saw the drop in gross margin in Q3 down to 23%, well below the company's expectation for 25.6% and the lowest since Q1 FY2012. The company has not been able to cut capacity as fast as sales are declining. In addition, enterprise drives carry the highest margin. The weakness seen in enterprise in Q3 is very disconcerting for the bulls. A low 20% gross margin will put added pressure on cash flow, which will quickly call the dividend into question.

I continue to believe the bulls have been very shortsighted in their analysis of this company. The high-level argument that the cloud will power the company's earnings for many years to come does not hold up to rigorous scrutiny. If you take away a majority of the client business (losses to SSDs, tablets, mobile-only consumers, etc.) there is no way that the enterprise and other ancillary businesses can support the current capital structure and the current dividend payout, especially considering the weakness we are now seeing in enterprise. Free cash flow has already declined from $1.9B in FY2015 to what could be below $1B in FY2016 ($1.1B LTM). There is no reason to expect these declines will abate anytime soon given the topline and margin pressure we are seeing. The current dividend costs the company $750M annually. If the current trend continues into FY2017, I would expect FCF to fall to near the level of the dividend payout next year. I know many investors are enamored with the current yield, but that is clearly not reason enough to own the stock. Today's drop alone wipes out more than two years of dividend payments. Cash flows are declining and there is little the company can do to stop it. Buybacks will all but stop if this continues. Soon the dividend will be called into question as free cash flow continues to decline. The company has run the cash balance down to near the minimum level it needs to run the business ($1B has been what the CFO has said in the past). Taking on additional debt to fund the dividend and buybacks is out of the question as leverage ratios have already increased due to declines in EBITDA and the interest rate would be exorbitant given the revenue and margin pressures. The stock absolutely does not deserve its current earnings multiple of nearly 12x. Given the rapid decline in the topline and complete lack of visibility into sales, I think 8x would be a generous multiple. The street's estimates for FY2017 are currently $3.26/share, but clearly those estimates are coming down. I do not see a path to 2017 EPS that is any higher than FY2016, which should be ~$2.40/share, possibly lower. If you use that number and an 8x multiple fair value for STX shares is $19.20. So even after today's drop the shares are not a bargain.

The sell-side is weighing in this morning as well. So far I have seen Morgan Stanley cut its price target to $23. It noted that this is the first sign of weakness in the mission critical enterprise HDD business. This accounts for ~25% of Seagate's profits. With OEMs moving to SSDs it believes the weakness will persist. Citi also cut its PT to $22 and reiterated its Sell rating. They believe the main reason for the gross margin miss was lack of visibility into sales. UBS also cut its PT to $22.

Once again I would implore everyone that owns Seagate for the current yield to move on to something more stable. Flash technology is being adopted at an increasing rate. Any tailwinds from the cloud are dissipating as more and more enterprise storage is moving to flash. Flash need not reach cost parody with HDDs for adoption to really spike - the performance improvements are reason enough for many to make the switch. The rest of Seagate's businesses are experiencing significant headwinds that are unlikely to dissipate anytime soon. I see no reason to have any confidence in a company experiencing 20% topline declines and shrinking margins. Revenues will continue to drop and margins could settle back to pre-industry consolidation levels in the high teens. In that scenario, the dividend absolutely will get cut. Don't wait for that to happen. Head to the exits now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.